Assignment: Dealing with Risk, Asymmetric Information, and Incentives

INTRODUCTION: • Choice of a company

• Continue research on Southwest Airlines, or

• Select another company, or

• Select the company you work for

• Size of paper

• Six to eight (6-8) pages

1. • Evaluate a company's recent (within the last year) actions dealing with risk and uncertainty.

• Difference between risk and uncertainty

• Risk is how we characterize uncertainty about values that vary.

• Risk is modeled using random variables multiplied by their probabilities.

• Uncertainty refers to the distribution of the random variables.

• Which probabilities should be assigned to the various values the random variables can take?

• When you're uncertain about the costs or bene?ts of a decision, replace numbers with random variables and compute expected costs and benefits.

• Analyze common types of uncertainty and risk your company faces. For example:

• Uncertainty in pricing

• Uncertainty in dealing with suppliers and distributers

2. • Offer advice for improving risk management.

• By modeling uncertainty, you can:

• Learn to make better decisions

• Identify the source(s) of risk in a decisions

• Compute the value of collecting more information.

• Difference-in-difference estimators are a good way to gather information about the bene?ts and costs of a decision.

• The ?rst difference is before versus after the decision or event.

• The second difference is the difference between a control and an experimental group.

• If you are facing a decision in which one of your alternatives would work well in one state of the world, and you are uncertain about which state of the world you are in, think about how to minimize expected error costs.

• Uncertainty is unavoidable. To cope with uncertainty, gather more or better information.

• Best Buy has used dispersed sets of non-experts to predict future variables, such as a holiday sales rate.

• Google uses internal prediction markets to generate demand and usage forecasting.

• The US Marines advise:

• Because we can never eliminate uncertainty, we must learn to fight effectively despite it. We can do this by developing simple, flexible plans; planning for likely contingencies; developing standing operating procedures; and fostering initiative among subordinates.

3. Examine an adverse selection problem your company isfacing and recommend how it should minimize its negative impact on transactions.

• Define adverse selection

• Adverse selection is a problem that arises from information asymmetry-anticipate it, and, if you can, ?gure out how to consummate the unconsummated wealth-creating transaction (for example, how to make low-risk customers pay for health insurance).

• Screening is an uninformed party's effort to learn the information that the more informed party has.

• Signaling is an informed party's effort to communicate her information to the less informed party.

• Lessons

• Anticipate adverse selection and protect yourself against it.

• Using screening or signaling helps overcome the adverse selection problem so that low-risk individuals can be transacted with profitably.

• Gather enough information to distinguish high-risk from low-risk consumers.

• Direct and indirect methods

• Information may be gathered indirectly by offering consumers a menu of choices, and consumers reveal information about their risks by the choices they make.

4. • Determine the ways your company is dealing with the moral hazard problem and suggest best practices used in the industry to deal with it.

• Moral hazard refers to the reduced incentive to exercise care once you purchase insurance.

• What is the difference between adverse selection and moral hazard?

• Adverse selection arises from hidden information about the type of individual you're dealing with.

• Moral hazard arises from hidden actions.

• The cost of managing both problems can be reduced by reducing uncertainty (gathering more information).

• Solutions to the problem of moral hazard center on efforts to eliminate the information asymmetry

• monitoring

• changing the incentives

• Example: Moral hazard in lending.

• This is a problem for both the lender and the borrower. If the bank anticipates moral hazard they
will be less willing to lend, or demand a higher interest rate.

• This incentive con?ict is only made worse when the borrower can put other people's money at risk.

• Borrowers take bigger risks with other people's money than they would with their own.

• To control this, lenders must ?nd ways to better align the incentives of borrowers with the goals of
lenders.

• Banks sometimes do this by requiring borrowers to put some of their own money at risk.

• This is why banks are much more willing to lend to borrowers who put a great deal of their own money at risk, but it also leads to the complaint that banks lend money only to those who don't need it.

5. • Identify a principal-agent problem in your company and evaluate the tools it uses to align incentives and improve profitability. (15 %)

• Principals want agents to work for their best interests, but agents typically
have different goals than do principals. This is called incentive con?ict.

• In a well-run organization, decision makers have

1) the information necessary to make good decisions and

2) the incentive to do so.

• If you decentralize decision-making authority, you should strengthen incentive compensation schemes.

• If you centralize decision-making authority, you should make sure to transfer specific knowledge (information) to the decision makers.

• To analyze principal-agent con?icts, focus on three questions:

• Who is making the bad decisions?

• Does the employee have enough information to make good decisions?

• Does the employee have the incentive (performance evaluation + reward system) to make good decisions?

• Alternatives for controlling principal-agent con?icts center on one of the following:

• Reassigning decision rights (to someone with better incentives or information)

• Transferring information

• Changing incentives (performance evaluation and reward system)

Organizational options

• Functional (U-form): A functionally organized ?rm is one in which various divisions perform separate tasks, such as production and sales.

• M-Form: An M-form ?rm is one whose divisions perform all the tasks necessary to serve customers of a particular product or in a particular region.

• Companies with functional divisions share functional expertise within a division and can more easily evaluate and reward division employees. However, change is costly, and senior management must coordinate the activities of the various divisions to ensure they work towards a common goal.

• Process teams are built around a multi-function task and are evaluated based on the success of the task.

6. • Examine the organizational structure of your company and suggests ways it can be changed to improve the overall profitability. (20 %)

• Three possible solutions for incentive conflicts

• Change the division that does the decision making,

• Change the flow of information, or

• Change a division's evaluation and compensation schemes

• Profit center

• The benefit of a profit center is that they are easy to evaluate (and manage); the cost is that they are concerned only with their own division profit.

• A cost center

• It is rewarded for reducing the cost of producing a specified output.

• You can get rid of the conflict by turning one division into a cost center.

• In a multi-divisional company, transactions between divisions can create incentive conflicts.

• To understand the source of conflicts that arise between divisions, personify the divisions and consider each to be a rational actor. Then ask the same three questions

1) Which division is making the bad decision?

2) Does the division have enough info. to make a good decision

3) Does it have the incentive to do so?

• The problems of corporate budgeting and how to fix it

FORMATTING REQUIREMENTS

• Be typed, double spaced, using Times New Roman font (size 12), with one-inch margins on all sides; citations and references must follow APA or school-specific format. Check with your professor for any additional instructions.

• Include a cover page containing the title of the assignment, the student's name, the professor's name, the course title, and the date. The cover page and the reference page are not included in the required assignment page length.